Research / BFI Working PaperMar 22, 2021

Sovereign Debt Ratchets and Welfare Destruction

Peter M. DeMarzo, Zhiguo He, Fabrice Tourre

An impatient and risk-neutral government can sell bonds at any time to a more patient group of competitive lenders. The key problem: the government cannot commit to either a particular financing strategy, or a default strategy. Despite risk-neutrality, in equilibrium debt adjusts slowly towards a target debt-to-income level, exacerbating booms and busts. Most strikingly, for any debt maturity structure, the gains from trade are entirely dissipated when trading opportunities are continuous, as lenders compete with each other and the government competes with itself. Moreover, citizens who are more patient than their government are strictly harmed by the unrestricted borrowing. We fully characterize debt dynamics, ergodics, and comparative statics when income follows a geometric Brownian motion, and analyze several commitment devices that allow the sovereign to recapture some gains from trade: self-imposed restrictions on debt issuances and levels, as well as “market-imposed” discipline.

More Research From These Scholars

BFI Working Paper Jun 15, 2020

Treasury Inconvenience Yields during the COVID-19 Crisis

Zhiguo He, Stefan Nagel, Zhaogang Song
Topics:  COVID-19, Financial Markets
BFI Working Paper Nov 20, 2019

Pledgeability and Asset Prices: Evidence from the Chinese Corporate Bond Markets

Hui Chen, Zhuo Chen, Zhiguo He, Jinyu Liu, Rengming Xie
Topics:  Financial Markets
BFI Working Paper Nov 25, 2019

Commonality in Credit Spread Changes: Dealer Inventory and Intermediary Distress

Zhiguo He, Paymon Khorrami, Zhaogang Song
Topics:  Uncategorized